Monday, June 7, 2010

Exact predictions of when the level of sovereign debt becomes a major burden on the economy of a nation state are difficult to make. What is infinitely easier to forecast is whether the national debt that has already been accumulated is sustainable or whether an impending financial crisis is inevitable.

No one indicator by itself provides enough ground for a definitive statement regarding the future. But when a plethora of the indicators regarding the country's ability to pay, the relative size of the debt level and liquidity metrics are all simultaneously violated then that is a completely different matter. The most common indicators of debt sustainability are those that present an idea about the medium term solvency of a country and those that speak to the issue of short term liquidity. For the purposes of this short presentation the following five ratios are to be highlighted:

1. National Debt to GDP ratio2. National Debt to Government revenue ratio3. Debt Service to GDP ratio4. Debt Service to Government Revenue ratio5. Debt Service to Government annual Budget ratio

Our interest in the above topic is not purely theoretical; it is primarily driven by the alarming metrics based on the current macro economic data for Lebanon. Only one of the above figures is commonly known by the general public in Lebanon a total National Debt /GDP ratio of over 160% at the end of 2009. But very seldom are the other figures mentioned either in the print press or in general discussions of the sovereign debt issue. Did you know that the level of government indebtedness is equivalent to over 7 years of government revenue and that debt service each year accounts for more than 55% of government income. Let me repeat this, over 55% of what the government raises in revenue each year goes to service the debt and only 45% are left for all other expenditures. Another ratio that expresses the same idea is that almost 14 % of the GDP is to be allocated each year to debt service.

Allow me at this stage to share with you a few figures culled from the Lebanese Ministry of Finance. These figures have a very sad story to tell. A story that we can neglect to deal with at our own peril. The nominal Lebanese GDP for 2009 is estimated to have been around $31.3 billion. The rather optimistic projections by the Lebanese government project a nominal GDP of $37.9 billion by the end of 2012. So what is wrong with this picture? Such a performance, if actualized is rather impressive isn’t it? Not quite. Each of the three years is also projected to carry a fiscal deficit and as we all know a deficit simply means that the government needs to borrow in order to bridge the shortfall in income. Based on the governments own estimates the deficit over these three years in question will total over $9.5 billion. Now it is rather clear, as clear as it can ever be, why is it that the Lebanese current national debt is not sustainable. Note that between the years 2009 and 2012 the GDP in nominal terms is expected to grow by $6.6 billion while the national debt meanwhile would have grown by $9.5 billions. The obvious question at this point is to ask for how long can such a situation go on? Solvency is going to become a huge issue for the simple reason that the debt service on the expected $61 billion of sovereign debt by the end of 2012 will amount to $4.27 billion at an average interest rate of 7% while the GDP of $38 billion would be expected to grow at only $2.66 billion even if a nominal rate of growth of 7% is attained which is rather unlikely.

For how long is denialism, the inability to acknowledge reality, to continue and when are we going to demand that the Lebanese authorities reevaluate the disastrous economic course that we are on.

Update:

There are a few who unwittingly subscribe to the false and misleading point of view of the government that Lebanon's salvation lies in following a policy of growing the GDP at a slightly larger rate than that of debt. Let me say unequivocally that such a strategy is dangerous especially in the short and the medium run. Mathematically it is correct that if GDP grows at a larger rate than the debt then the debt will become more managable. There are two obvious problems with this strategy. (1) Since the GDP must always grow at a faster rate than the debt whose minimum interest rate is say, 7% then the GDP must grow at a larger rate than that , say 8%. That is next to impossible under normal circumstances. (2) Even if the above is to be accomplished then it will not be of much help because this slightly larger growth rate is applied to a lower base and so the Debt/GDP ratio will drop slightly when the gap between the debt and GDP will increase. Let me illustrate: Assume at the starting point GDP was 30 while debt was 59. Further more assume that GDP grows at 8% each year for 10 years and that the debt grows by 7% each year for ten years. At the end of the 10 years the GDP would have grown to 64,8 an increase of 34.8 while the debt would have become 98,4 an increase of 48.3

Note that in the above illustration the ratio of Debt/GDP drops from 167 to 152 but that all the growth in the GDP was only 60% of the growth in debt !!! So the slight drop in the Debt/GDP ratio in this case was meaningless.

For Lebanon, to become an attractive economy its debt/GDP ratio must be cut in half to become sustainable. That requires a drop in the level of indebtedness by over $25 billion from the present levels. Anything else is to be filed under "denialism"; the inability to face the truth.

AIG, Rouhly 40% of the debt is issued in foreign currency, essentially US dollars while the other 60 % is denominated in Lebanese currency.

The Lebanese authorities including the central bank are infatuated with the fact that they are literally speaking swimming in excess liquidity due to the large amounts of financial inflows into Lebanon. These inflows exceed the need for financing the debt to the extent that the Central Bank is forced to mount liquidity mop up efforts by offering the local banks high interest rate CDs. But this is not as healthy as it looks. The inflow of funds is not being attracted to the coutry by real investment opportunities. The fund flows are to a large extent due to the relatively high interest rates that the local banks are offering. The banks take the money and use it in turn to finance the national debt. But what will happen if and when these artificial inflows stop or slow down?

Lebanon will have to eventually bite the bullet and seek some sort of debt relief including restructuring/moratorium/default.

Unfortunately your last point does not apply to the Lebanese situation. Those that recognize the severity of the crisis tend to be of the opposition and so they can care less if war results in a financial crisis while the March 14 cannot afford to admit that there is a debt problem because that will tarnish the image of the new Lebanese "saint rafik"